Investing in Bonds

The bond market in the United States today is enormous. There is over $3 trillion worth of outstanding bonds in the U.S. Treasury alone, and another $2 trillion in the corporate bond market. And there are countless thousands of companies in which to invest in bonds, too, and which company is financially the best can be a tough decision to make. How does one go about it?

A bond is a unit of credit, unlike a stock, which is a unit of ownership. Bonds can have certain advantages over stocks. The bond market may rise while the stock market is falling. And the day- to- day volatility (a financial instrument's fluctuation in price over a period of time) of bonds tends to be lower than that of stocks, plus the interest rate is often higher than the general rate for dividends. Bondholders may also get at least some money back if the company in which they have invested fails, whereas stockholders in the same situation have no such guarantee: stock often ceases to have value beyond the lifetime of the corporation.

There are, of course, disadvantages of bonds over stocks. One is that the latter is more liquid, making stocks much easier to sell. Bonds also carry their own risks, such as credit, interest rate, exchange rate, and volatility risk. And depending on the issuing corporation's credit rating, bonds can become volatile. Another danger is that of reinvestment risk, which occurs when the corporation decides to pay off the bond prematurely, forcing the creditor to reinvest his money elsewhere, often with less profitable returns, especially if interest rates are going down, which is when such is most likely to occur.

Anyone wishing to invest in bonds, therefore, must do his homework and make sure the benefits of his investment outweigh the potential costs. One way is to use a bond market index- some of the most prominent are the Salomon Broad Investment Grade Index, the Barclays Capital Aggregate Bond Aggregate, and Merrill Lynch Domestic Master, each of which monitors different types of investment portfolios.

Contrary to what many people believe, it is not always best to buy bonds at issuance and hold onto them until they mature. Yield is, in fact, not a good indication of total return. Active management is the key- and that means closely monitoring the bond market to see where the greatest returns potential lies, being prepared if necessary to reinvest elsewhere.

The government itself, on its various levels, can also be a profitable place to invest in bonds. U.S. Treasury securities, in particular, offer high yield compared to other bond securities, and so many Americans are investing in them. The federal government guarantees timely payment of interest on treasury securities, which also offer the advantage of being exempt from state and local (but not federal) taxes.

Municipal bonds are also becoming popular, in part because they provide one of the few remaining untaxable sources of income (though some are subject to the federal alternative minimum tax, so be sure to check if yours is).

No bond investment strategy is 100% foolproof. There is never any guarantee that a corporation will have any amount of money to repay its bondholders. Above all, diversification is an indispensable part of investing. Never put all of your eggs into one basket.